US Priced For Deflation! Riding The Tiger?

There was a day in October when central banks needed an urgent discussion. The S&P 500 had just fallen almost 10% in just a few days. The S&P 500 was barely positive for the year and just about everything else was negative except Treasuries. With the end of QE could the central banks really just leave the markets alone?

If the markets continued to fall what would they do? They can’t cut interest rates. It would be embarrassing to invoke another round of QE even before the last program had even finished. That would not play very well. What was plan B? An awkward silence was probably the answer, followed by panic.

The rest is history. Fed Governor Bullard rushed on to Bloomberg to say the central banks “can not abide” low inflation expectations being priced into the markets. Since that time inflation expectations have collapsed much further and have now turned negative! However, the market quickly realized that Bullard was just using code words for “buy stocks”! Banks and central banks went on a buying frenzy highlighted by the astonishing announcement at the end of October from the Bank of Japan, which went to new extremes of money printing and even explicitly mentioned it was buying stocks!

The rally since the lows of October is the strongest streak in 86 years. Stock market rallies are very useful for policy makers, they deflect all criticism, keep the status quo going, and they provide plausibility for all manner of interpretations of what is really going on in the mysterious ill-defined “economy”.

However, if you turn off the financial media and look dispassionately at the data it is as clear as it could be that the world economy is in an intensifying “Quad 4”. There are only 4 different variations of rising and falling inflation and growth. Now growth and inflation are falling – hence Quad 4.

Here is the landscape which seems very hard to dispute:

Commodities have crashed, especially oil.

Many emerging markets have crashed. ILF is at new 5 year lows.

High yield debt has crashed.

S&P 500 core earnings are declining.

US Equities are at their highest ever valuation, except for a brief period around 2000.

Deflation is now priced in the US markets.

World growth continues to decline.

Links are provided below for evidence of most of these assertions. Many are not in dispute.

All of the above points are consistent with Quad 4. As most emerging markets are reflecting, equity markets naturally decline in Quad 4, particularly when they are expensively priced.

However, where central banks are active and powerful equity markets are rising! This means that equity markets in “developed” countries represent much more than equity markets that are just being influenced by central banks. The direction of natural price development is in some cases being completely reversed!

In this case trying to use any normal economic or value approach to investing will become ineffective, it may also even lead to losing propositions in many cases. No wonder hedge funds are closing at a record pace!

What this means is that while investors with a heavy equity exposure have done very well they should realize they are riding the tiger with the central banks. The risks are extraordinary and the process is unsustainable and subject to rapidly diminishing returns.

This is a time to get a strategy that covers all contingencies. It may not be perfect but at some stage soon the investment outcome will be determined by who did and who did not have a plan.